Friday, February 26, 2010

The Pound in your Pocket

Since the devaluation crisis of 1967, the UK has followed a policy where problems that emerge in the economy are cushioned by devaluing the currency. The poor productivity of the British economy has thus been mitigated to a great extent. In fact, since 1992 when the Conservative government was forced to leave the exchange rate mechanism, which closely linked European currencies, Tories have tended to regard keeping the right to devalue as a key part of maintaining British competitiveness. They dress this up in the Union Jack: "Keep the Pound!", with the unspoken message that other currencies are a lesser store of value and somehow inferior. In fact despite the instability in the Euro over the past few weeks, Sterling has performed worse. British inflation is higher, and so are British interest rates. The fact is that British currency policy, as with so many other British industrial and economic policies over the past forty years, has been an exercise in taking the soft option.

The failure to take on the Kremlin funded trade unions of the 1970s. The failure to broaden our education system and promote the value of hard work, the failure to modernise our infrastructure rapidly enough, the failure of management, the failure of industry, all have been mitigated by allowing Sterling to fall at key moments. Yet there has been a major price for this. In order to maintain investment levels the British economy has had to operate under significant constraints. The UK was forced to keep government debt low, even while household debt - mostly to fund housing and consumption- exploded: the UK was not investing, it was spending.

Now, the collapse of the financial sector has severely damaged one of the primary earnings streams of the British economy. In order to fill the gap, the once relatively low levels of government debt have been nearly doubled over eighteen months. The government deficit- high even in the boom years- is now over 16% of GDP, and the highest in Europe. The UK monetary authority, the Bank of England, desperate to avoid deflation, has massively increased the monetary mass- yet the economy has seen no real GDP growth, and inflation, usually higher than our competitors, has begun to track upwards: the spectre of British "stagflation" is now a reality. Confidence is falling at a critical moment: people no longer talk about "V-" or "U-" shaped recovery, but "double dip" or even "L-" shaped, that is no recovery at all.

The British economy remains fundamentally unbalanced, with low interest rates not stimulating industrial investment, but simply continuing to fund grossly overvalued housing. It is quite clear that the unregulated estate agents are certainly not economists: how else could they speak of the housing market being "affordable" simply because short term interest rates are at historic lows. Just remembering that the average base rate since the Bank of England was founded in 1694 has been 5% should tell you that over the life of a 25 year mortgage it is that number -not the current 0.5% base rate- that is important. Using that as your discount rate will demonstrate at least a 20% overvalue in UK real estate prices.

Yet- the cautious bulls respond- that the damage that a rise in rates would cause, not least by increasing the cost of the dramatically increased government borrowing, means that rates will not rise. My response is that such a decision is not necessarily in the hands of the government or the Bank of England. The Government will need to sell a very large amount of government securities- "Gilts"- in order to fund this years deficit. Without an appropriate interest rate to compensate the risks that investors are taking on, there could indeed be the feared "Gilts strike", where investors refuse to fund the deficit. Although the Labour government may seem to think so, the fact is that the UK Treasury does not have a limitless pool of capital and the laws of demand and supply continue to operate in government securities as in any other market.

This brings us back to the Pound. The policy over the past two years has been to permit a devaluation greater than at practically any time in history and to print money through the quantitative easing programme. Despite all of this, and a drastic increase in the government deficit, the UK economy is still exceptionally weak. Our capacity to earn enough to repay the debts we are incurring is still falling. The result will be two-fold. Firstly interest rates will- inevitably- have to rise sharply over the course of 2010, which will negatively impact growth, making the problem worse. Secondly the value of Sterling will fall to reflect the higher risk and lower capacity of the economy. In addition there could be sharp speculative runs on Sterling, especially if the political outlook around the election continues to grow less clear.

The tertiary impact could then well be the correction in UK real estate market that everyone except UK estate agents forecasts. The impact of that will probably be that the UK banking system- particularly the building societies- will be weakened still further.

No one can be certain about the future, but even the prospect of this negative scenario will have a strongly negative impact on the Pound. In short the currency is in mid air- and the next few weeks could well see an old fashioned Sterling crisis. The long term policy of devaluation may be about to hit the buffers.

Then the really hard work of true structural reform and a fundamental realignment of the economy to make it sustainable for the long term must begin. It is going to be at least a decade of real slog.

1 comment:

Newmania said...

The failure to take on the Kremlin funded unions ...was at a time when your Party were in a pact with the Union funded Labour Party. The accusation tat the Conservative Party is oblivious to the advantages of currency alignment and free trade is , shall we say, an interesting interpretation recent history . What would you had had Major do? Where was the supprt from the Lib Dems ?
That you are heedless of the political implications of the centralised control required hardly needs saying.
For all this there is much here that I heartily agree with .That is why I am dismayed to see Peter Hain , unchallenged by Nick Clegg announcing in today’s Guardian , that Labour and Lib Dems are part of the broad constituency who feel we must go on spending and continue in the informal pact of the last ten years .

Where you are , in my view, so right is to look at the long term supply side . Listening to the economist establishment you would think a group stranded on a Desert island only had to call leaves currency to live in paradisal affluence. A bit of demand management , issuing gilts buying them with leaves and Robert est votre Oncle .

Somebody has to go fishing and overall I like this article .You make a better pro EU /single currency case than the pro EU Conservatives ever did and you are at least worrying about the right things.